P A R T I A Trader’s Journey COPYRIGHTED MATERIAL c01 7 June 3, 2014 10:07 PM CHAPTER 1 T he Birth of a Trader t was 1989, and I was California dreamin’. Actually I wasn’t dreaming, I was al- ready in California, living a young single man’s dream. A year or so out of college, I 9 I was residing in sunny Manhattan Beach, California, with a small apartment three blocks from the soft white sand so wonderful that they used it to help create Waikiki Beach in Hawaii. I had graduated the year before, summa cum laude, with a bach- elor’s degree in aerospace engineering from the University of Michigan, a top‐tier engineering school. Then I had turned my back on Massachusetts Institute of Tech- nology (MIT), California Institute of Technology (Cal Tech), Stanford University, Purdue University, and Michigan, all of whom had accepted me in their aerospace master’s degree program. I turned down those great schools to live and work in sunny California, a lifelong dream. I still remember the precise moment I made that fateful decision. On a bitterly cold winter’s day in Ann Arbor, Michigan, I was walking down South University Avenue to one of my fi nal‐semester classes. The wind was blowing so hard in my face that I actually leaned into the wind to see if it would keep me up. At that point, fall- ing face‐fi rst onto the ice‐covered sidewalk would not have been much worse than feeling the stinging wind in my face. What seemed like a gale‐force wind kept me upright, and then I knew—I did not want, or need, to live where it was cold in the winter when aerospace engineering graduates like me were fl ocking to jobs in sunny southern California. My mind was made up. Sun and sand it was. A few weeks after graduation, I packed up my belongings, and with my sister Karen as my driving companion, drove cross‐country to warm and sunny Los Angeles. c01 9 June 3, 2014 10:07 PM One year later, I was settled in. I had a close group of friends, most of them Midwestern transplants like me. We’d while away the weekends playing beach volleyball, usually capping the day off with a few drinks at a local pub. I loved beach living and all the entertainment it provided. Driving around the beach cities in my little red T‐roof sports car, life was pretty good. But something was missing. I couldn’t put my fi nger on it, but I knew this wasn’t the life for me. Well, beach life certainly agreed with me, but my choice of career was the wrong one. Sure, designing future fig hter airplanes and working on secret government projects was fulfi lling to a degree. But I just didn’t feel like it was my future. I could not see my- self doing that kind of work for even 5 years, much less a career of 30 or 40 years. I needed a jolt to wake me up. That jolt came in the form of junk mail that appeared in my mailbox one day, and it changed everything. T he junk mail booklet was from Ken Roberts, a futures and commodities trader. Or at least that is how he presented himself. Looking back on it, he was defi nitely more of a salesman than a trader. With a nice, folksy smile and a cowboy hat, Ken laid out the riches that awaited anyone brave enough to trade futures, or commodities, as they were more commonly referred to back then. He had a compelling story in that little booklet of his, and I’ll admit I was quickly 10 hooked. Looking at a chart of sugar, as shown in Figure 1.1 , seeing all the potential profi t just waiting for me, how could I not be? At that point, words like drawdown, risk of ruin, and emotional controll were not in my RADER T vocabulary. But massive profi ts, easy money, and s imple trading suddenly were! And with F A a money‐back guarantee, how could I go wrong? It was a risk‐free entry pass into a O world of unlimited profi t potential—or so my naive self‐thought. So I sent a check H T and dreamed that night about all the riches that would soon be fl owing my way. A few weeks later, I received the full trading course. It was a hefty manual, full of HE BIR T charts with profi table examples. Initially, I was duly impressed. But then I started to 46-point rise in sugar in 5 months = $51,520 profit per contract FIGURE 1.1 S u gar Skyrocketing = Unlimited Profi ts? c01 10 June 3, 2014 10:07 PM Head Shoulder Shoulder Signal to sell short FIGURE 1.2 Good Head and Shoulders Pattern or Just a False Signal? look a little closer at the details. Turns out the whole course was primarily based on the 1‐2‐3 head and shoulders pattern. As most traders and investors know, this pat- tern is a classic chart pattern, as shown in Figure 1.2 . It is easy to fi nd on just about any chart you look at—you can fi nd a profi table example or two on most any chart, any instrument, and any time frame. The problem is that the head and shoulders pattern gives a lot of false signals and 11 usually looks good only in hindsight. Of course, I did not know that at fi rst. I only T HE BIR knew I could look at a chart, pick out the head and shoulders pattern, and see how well it worked. T I eventually found out I was missing two key pieces of the puzzle. First, when you A H OF look at a chart with a head and shoulders or any other pattern in it, it is easy to see T the winning trades because you are looking at both the pattern and the outcome of RADER that pattern. If you try hiding the outcome of a pattern, it becomes much more dif- fi cult to fi nd theg ood patterns. The second key I was missing is that the existence of a pattern, by itself, doesn’t necessarily mean a trade should be taken. If you take every single head and shoulders trade you see, you will soon be broke, as shown in Figure 1.3 . Of course, the naive wannabe trader in me was oblivious to this fact. After a month of dutifully following and paper trading all the head and shoulders signals, and fi nding most of them to be unprofi table, I sent all my trading records, along with the manual, back for a refund. True to his word, Mr. Roberts refunded my money. My dream of trading riches was shattered, at least temporarily. On the bright side, I now saw futures as the way to go—I just realized head and shoulders patterns were not going to be the way. Once I abandoned the get‐rich‐quick idea with the 1‐2‐3 head and shoulders patterns, I did what many scientifi c, numbers‐oriented people do: I looked to mathematical formulas to help me in my decision making. And I started where many people do: moving averages. c01 11 June 3, 2014 10:07 PM Head and shoulders failed Head Shoulder Shoulder Signal to sell short FIGURE 1.3 Many Head and Shoulders Look Good but Eventually Fail ■ My Moving Average Debacle I’m sure every trader or investor has seen or used moving averages at some point in their trading career. Moving averages are a great way to see the general market direction, simplifying sometimes chaotic price action. But it comes at a price—lag. Moving averages will always lag whatever their calculation is based on, which can be 12 a major problem. There are many ways to trade with moving averages. In the simplest method, you RADER simply buy when the price is above the moving average, and sell (or sell short) when T price is below the moving average. This scheme works very well during prolonged F A O trends, but gets absolutely hammered during trading range price action (see Figure 1.4 ). H T Early market technician pioneers rectifi ed this by employing two, or even three, moving averages. By using more moving averages, the idea was to fi lter out some fo HE BIR the trading range whipsaw trades, and leave the long‐term, profi table trend trades. T Dual moving average works great in trends Dual moving average crossover system prone to whipsaw losses FIGURE 1.4 Great in Trends, Moving Averages Fail in Trading Ranges c01 12 June 3, 2014 10:07 PM Trade locations are hard to see with many moving average crossovers FIGURE 1.5 T r i p le Moving Average Crossovers Can Be Deceiving After my unsuccessful foray into futures with chart patterns, I was struck by the apparent awesomeness and simplicity of the triple moving average. Looking at a chart, it was easy to see the profi table trades, while the unprofi table whipsaw trades were much harder to detect (see Figure 1.5 ). During the whipsaw periods, the mov- ing average lines were very close together, and seeing crosses of lines was exceedingly diffi cult. Obviously, I had learned little from my head and shoulders experience, 13 T where what I saw on the chart was deceiving me.